Midterm Elections And Historical Stock Market Performance

trying year continues to drag on for investors with the DJIA down over 15%, the S&P 500 down over 20% and the Nasdaq Composite down over 30%. By any measure, this has been a brutal bear market for US stocks.

On top of a volatile and contentious period for equities, US politics have also been rancorous. As we roll into what should be a tightly-contested election season, O’Neil Global Advisors (OGA), with assistance from our sister company, William O’Neil +Co. (WON) examined the market history with regards to midterm elections.

So far this year, the relationship and direction of past patterns have held up, to an exaggerated degree, with each quarter’s performance coming in far weaker than the long-term averages. Using history as a guide, things are progressing as expected for the second year of a first-term president.

Normally, after a weak nine months through September, the fourth quarter in the second year of a president’s first term has had positive performance returns as shown in the bar chart below. As of October 17, the US stock indices have risen 3-4% to start the current quarter.

Looking further out, after a hard second year, the third year of presidencies are historically very strong on average. In fact, they are usually the best of the four-year cycle. As the chart below demonstrates, this is especially true with the Nasdaq Composite, which tends to favor growth stocks.

Normally, these third-year gains are concentrated in the first half of the year and build upon gains for the second year’s Q4. If this pattern plays out this time, the market could begin a move higher soon. By the second half of a president’s third year, these gains slow.

Below is the overall performance of the third year of presidential terms going back 120 years for the DJIA. OGA uses this index for much of our work because the data go back further in time than the S&P 500 or the Nasdaq Composite. The DJIA has only been negative six times out of 30 and just once in 18 instances since 1950. Given this history and the magnitude of this year’s selloff, we are cautiously optimistic that 2023 will be a good year for stock returns.

From a technical perspective, the current stock market remains weak. At this point, OGA is looking for a sixth Follow-Through-Day (FTD), defined essentially as a large gain on heavy volume. As is typical in a bear market, the prior five FTDs have failed by undercutting the previously established low. It is worth noting that the average number of failed FTDs in bear markets years is six, excluding the outliers of 1987 and 2020, which were more V-shaped recoveries and had no failed FTDs. When one includes those two bear markets in the sample, the average number of FTDs before the equity market turns is 4.5. However, in deep bear markets, such as occurred in 1973, 2000, and 2007, it is not uncommon to see seven or more FTDs before the market finally reaches a bottom.

Currently, leadership is narrow and confined primarily to Energy and defensive ideas, with some financials, notably regional banks performing well recently. Technology and Consumer Cyclicals remain the most troubled, consistent with a general “risk-off” environment. The Technology ETF (XLK
XLK
) made a new 16-month low relative to the S&P 500 just this week. We believe Technology’s performance should bottom with the overall market.

Given the damage done to stocks, an FTD alone would not be enough to make us completely bullish. We would need to see several additional signals emerge for more confidence. These include a retake of not just the short-term 21-Day Moving Average (DMA) but also the 50-DMA and eventually the 200-DMA. The S&P 500 is 10% below the 200-DMA. A break above the August 2022 peak would represent a higher high and could be the confirmation of a new, more sustainable uptrend. Also, we would like to observe much higher stock breakout totals, meaning stocks emerging from technical price bases. The line chart below shows our proprietary indicator of Weekly Stock Breakouts in the US. Normally, a breakout from a price base or consolidation results in a strong upward price move for a stock. Spikes in stocks breaking out are the sign of a healthy and rising market. We would like to see a very large spike of breakouts, not just an average total (~100), to become more bullish. Historically, these spikes tend to occur 4-6 months after market lows.

In conclusion, the present stock market environment continues to follow an exaggerated version of normal second year presidency patterns. Given the declines experienced so far, a fourth quarter relief rally would not be unusual. However, until the US market has a successful FTD and a large increase in stock breakouts, we remain cautious about declaring that the final bottom of the bear market has been reached. Nonetheless, if history holds, after this year of declines, 2023 offers potential for meaningfully better equity returns.

This article was co-authored by William O’Neil +Co. Global Sector Strategist, Kenley Scott. Mr. Scott lends his perspective to the firm’s weekly sector highlights and writes the Global Sector Strategy, which highlights emerging thematic and sector strength and weakness across 48 countries globally. A key tenet of written research is utilizing the extensive William O’Neil database to profile historical market cycles and stock and then attempt to draw relation to the current environment. He also covers global Energy, Basic Material, and Transportation sectors and serves as a member of the Global Focus List Committee, which approves all equity recommendations for developed, emerging, and frontier markets. After working as a commodities broker, Kenley joined the firm in July 2006. He has a B.S. in Statistics from the University of California, Riverside and also holds a Series 65 securities license.

DISCLOSURE:

No part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed herein. O’Neil Global Advisors, its affiliates, and/or their respective officers, directors, or employees may have interests, or long or short positions, and may at any time make purchases or sales as a principal or agent of the securities referred to herein.